What is the inventory system that updates the inventory account continuously?

A perpetual inventory system is an accounting and inventory management method that continuously tracks and records inventory changes (with every transaction). It does this using supply chain management software and digital input devices such as point-of-sale (PoS) systems and barcode/RFID scanners. Along with the periodic inventory system, it is one of the two most employed and accepted methods to account for inventory

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The idea behind the perpetual inventory method is to turn stock-keeping into a constant, digitized, real-time activity instead of a periodic and manual one. It involves a lot more data processing, but the advantages of perpetual inventory outweigh that hassle – especially with modern digital technology.

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How Does It Work?

At its simplest, a perpetual inventory system involves tracking, recording and updating all changes made to your inventory as-and-when they happen, for goods received, used for production or sold (at the PoS). Here’s an example of how it could proceed:

1. Monitor Changes In Inventory: When an item in your inventory is sold or used for production, barcode/RFID scanners can send this data to the inventory management software to update general and inventory ledgers and apply this debit across the system. This step would also be the same in receiving items and adding them to the inventory.
2. Update COGS: The data from the last step is used to recalculate and update the cost of goods sold (COGS) automatically. You can do this using your preferred costing method, be it first-in-first-out (FIFO), last-in-first-out (LIFO) or weighted/moving average.
3. Reset the ROPs: The system updates the reorder points (ROP) – the minimum quantity any item in your inventory must reach to warrant a replenishment — using the data collected.
4. Generate POs: According to the new ROPs, the system will automatically generate any purchase orders (PO) as required, ensuring your inventory stays well stocked. The generation and sending (to suppliers) of POs are automated and require no human effort.
5. Monitor Inventory Changes: Circling back to step one, the system will re-update your databases based on the newly received inventory as your warehouse team scans and adds it through their warehouse management system.

The example above is just one way to set the system up. Depending on the structure of your organization’s supply chain management system, existing ERP systems and the different procedural infrastructures, perpetual inventory systems can be configured to fit exact requirements.

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Perpetual vs. Periodic

The main difference between perpetual and periodic inventory systems is in the frequency of updating the inventory data (in the warehouse as well as central ledgers). Periodic inventory systems use set intervals (such as monthly or annually) or accounting periods to track inventory and update databases. Perpetual systems use a continuous process to monitor transactions and update inventory databases automatically, in real-time.

This fundamental difference affects inventory and warehouse management at multiple levels:

• Account Updates: Perpetual systems will update inventory and general ledgers continuously and automatically with each transaction. Periodic systems depend upon physical counts to update ledgers at set intervals.
• COGS Calculation: A running tally of transactions in perpetual systems allow COGS calculation at any time. Periodic systems can only calculate COGS accurately at the end of an accounting period after conducting a physical inventory count.
• Implementation Method: Perpetual systems require implementation through software due to the large volume of transactions they track. Periodic systems allow manual implementation without the use of any software technology.
• Purchase Recording: Perpetual inventory systems log purchases in the inventory account for raw materials or merchandise. Periodic systems record purchases into purchase asset accounts without any data on unit counts.
• Inventory Investigation: Errors in inventory records are easier to investigate in perpetual systems, as detailed data is recorded at a transaction level. Periodic systems make investigations more complicated, as the data available is at a level too macro to pinpoint errors. You’ll read more on this in a bit.
• Stock-keeping Method: Perpetual inventory lets you implement alternative counting methods that periodic systems do not – such as cycle counting. Cycle counting enables you to segment your inventory into different units to count individually and assimilates that data into your central databases. This way, the entire inventory doesn’t have to be counted at once.

Setting up a software-driven perpetual inventory system. Source

Moreover, periodic inventory systems typically require employees to stop warehouse activity and take a physical inventory count. They then compare this with the data in the sales and general ledgers. The process also involves regular inventory audits and other time-consuming manual activities.

Perpetual inventory can eliminate all the time and effort expended in such activities through automation and continuous collection and updating of inventory data.

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Pros and Cons

Like all business management systems, the perpetual inventory system isn’t all benefits and advantages. Depending on the organization’s products, infrastructure, scale and capabilities, there are good reasons to choose (or not choose) perpetual inventory. Let’s explore some of these considerations:

Pros

Perpetual inventory is the preferred method of inventory management, especially for organizations with high-volume inventories, and for good reason! Here are the more important ones:

• Access to Real-time Data: The continuous recording of all transaction data (sales, returns, discounts, etc.) creates a living database with instant access for all stakeholders. This access lets businesses make better decisions across all operations based on the most recent data. It also allows them to make continuous tweaks and adjustments to foster continual improvement in their business processes.
• Micro-level Data Collection: Data collection at the transactional level builds a more detailed database, letting businesses predict future conditions more accurately. Long-term decision-making becomes much easier with a more detailed paper trail that helps identify performance indicators. Leverage real data to conduct accurate demand-forecasting and subsequent optimization of inventory levels.
• Reduced Costs: The overall cost of inventory management drops significantly by implementing a perpetual inventory system. Though the initial cost of setting it up may be high (depending on your organization’s size), recurring staffing costs are prominently decreased by eliminating the need for daily manual checks and counts by staff, saving both time and money.
• Easy Investigation: With a continuous stream of transactional data, you can investigate stock discrepancies more efficiently and accurately. Micro-level data collection gives you more accurate inventory numbers to work with, making it easier to detect and prevent instances of shrinkage, counting errors and theft. In a periodic system, these discrepancies are easy to overlook as it uses a physical inventory count to balance year-end inventory and calculate COGS.

Cons

When it comes to inventory management, there is no one-size-fits-all solution, and the perpetual inventory method is no exception. Here are some reasons you may not want to choose it:

• Technological Dependence: Implementing perpetual inventory systems requires significant technological infrastructure, including both software and hardware tools like warehouse management software, barcode/RFID scanners and PoS systems. This creates two significant challenges –
  • Setup Costs: Financial requirements for buying, maintaining and deploying the software/hardware.
  • Employee Training: Time and money needed to train employees to properly use the technology involved.

  By comparison, periodic inventory systems typically use manual processes for counting and recording your inventory, as well as making changes to your inventory ledgers. For smaller businesses with low-volume inventory and a limited budget, this may still be the more feasible option.

• Margin-of-Error: Though computers make fewer errors than humans, it is possible, especially as some human activity is involved in some steps (such as scanning items). This, combined with the human tendency to adopt corrupt practices like theft, makes it necessary for physical counts to verify inventory data. For businesses with low-volume and high-value products (like car dealerships or jewelry stores), it makes more sense to employ periodic inventory methods and conduct physical inventory checks.
• Breakage Of Items: You can update inventory levels using purchase and sales data to ensure quick record keeping. In case any item breaks, gets spoilt and is unsaleable, it’s considered part of the inventory. Unless there is an actual physical count to update the broken item’s data in the system, perpetual inventory system stands at a disadvantage.

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Who Uses the Perpetual Inventory System?

Do you deal with large inventory quantities and are looking to scale your business? Doesn’t matter what your industry size is because investing in a perpetual inventory system is just what you need.

If you are running a large business, keeping track of inventory can be tedious. Unless you have a regularly updated database of products to automate, control and track inventory. With perpetual inventory, you can access real-time information without hopping around between your multiple warehouses.

Perpetual inventory is also a big hit when it comes to dropshipping since here inventory is always on the move and keeping a constant count is necessary. The supplier-reliant model of dropshipping coordinates order data and helps prevent stockouts.

Which Should You Choose?

As you’ve probably guessed from the section above, there are , and their validity depends on certain parameters of your business:

Inventory and Transaction Volume

Your inventory’s size significantly affects which of these two methods suits you. For most businesses with a high inventory volume, the perpetual inventory method’s benefits are overwhelming. This is simply due to the time and effort required to perform physical counts of their inventory. Add a high transaction volume to that, and the effect compounds! A large number of transactions automatically allows the perpetual method to create extensive databases that benefit all business operations.

Periodic inventory systems can only be viable for businesses with low inventory volume. While that doesn’t necessarily mean that your transaction volume is also low — but the chances are high! Businesses such as car dealerships or jewelry stores (with low transaction and inventory volume but very high-value products) typically have an easier time with the periodic method, especially to ensure zero discrepancies.

Location Diversity

If your business has multiple locations with frequent inventory transfers, inventory management becomes much more complicated. In such cases, the perpetual system is the better choice by far. It automatically creates a centralized inventory database across locations, cutting down the chances for error. Periodic systems would involve handling multiple databases and the need to expend extra effort in ensuring that the data concurs. The costs incurred (both time and money) for such a business to maintain periodic inventory counts are much higher, making it an impractical choice.

Perpetual inventory system generating multi-location transaction history. Source

Budget

The most obvious consideration is probably your budget — whether you can reasonably invest in a perpetual system’s initial setup cost. The infrastructure required to implement this method accurately is significant, bringing with it a financial burden that small businesses may not be able to shoulder.

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Final Thoughts

The perpetual inventory system is the preferred accounting method for industry leaders globally, but it requires an adequate technological framework to implement within. It is undoubtedly the better accounting and inventory management method if your organization can streamline the software selection process, handle the initial costs and maintain the system without errors.

That said, it always pays to be careful, and it is highly advisable to periodically conduct physical inventory counts and make sure your data matches what the ledgers show.

Which inventory method do you think suits your business best, and why? Let us know in the comments below!

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